Behavioral Finance V1

What does the concave shape of a utility function represent?

Risk aversion — diminishing marginal utility of wealth.

What is Certainty Equivalent Wealth (CEW)?

The guaranteed wealth that yields the same utility as a risky prospect.

How is the certainty equivalent (CE) defined?

The amount a person would accept instead of a risky gamble — equal in utility to the gamble’s expected utility.

How do you calculate the risk premium?

Risk premium = Expected value (E[x]) – Certainty Equivalent (CE).

What is Absolute Risk Aversion (ARA)?

ARA = -U''(x)/U'(x); measures how averse an individual is to small risks.

What is Relative Risk Aversion (RRA)?

RRA = -x * U''(x)/U'(x); adjusts risk aversion for level of wealth.

What is a risk-neutral investor?

One who is indifferent between a certain amount and a gamble with the same expected value.

Describe the shape of the Prospect Theory value function.

S-shaped: concave for gains, convex for losses, steeper in the loss domain (loss aversion).

What is loss aversion?

Losses feel about 2.25 times more painful than equivalent gains feel pleasurable.

What is probability weighting in Prospect Theory?

People overweight small probabilities and underweight large ones.

What is the reflection effect?

Preference reversal: risk-averse in gains, risk-seeking in losses.

What does the certainty effect demonstrate?

Preference for certain outcomes over probabilistic ones, even when expected values are similar.

What is mental accounting?

The process of categorizing and evaluating economic outcomes by grouping them into “accounts.”

What is the difference between segregation and integration in mental accounting?

Segregation: evaluating each gain/loss separately; Integration: evaluating gains/losses together.

How does framing affect decision-making?

Presentation of outcomes affects choice, even if outcomes are identical.

What are the two main forms of overconfidence?

Miscalibration and better-than-average effect.

What is miscalibration?

Overestimating the accuracy of one’s own knowledge or predictions.

What is the better-than-average effect?

Believing one's abilities are superior to others.

What is anchoring?

Overreliance on an initial value or reference point when making decisions.

What is representativeness?

Judging likelihood based on similarity to existing stereotypes.

What is the availability heuristic?

Estimating likelihoods based on how easily examples come to mind.

What is herding behavior?

Copying others’ actions due to fear of standing out or missing out.

How do anchoring and herding differ?

Anchoring is about internal bias to prior values; herding is conformity to others' observed actions.

What is the disposition effect?

Selling winners too early and holding losers too long due to realization utility or regret aversion.

What is home bias?

The tendency to overinvest in one’s home country despite potential diversification benefits abroad.

What is attention bias?

Overweighting salient or recent information in investment decisions.

What is the difference between a good company and a good stock?

A good company has solid fundamentals; a good stock is priced attractively relative to fundamentals.

What is the difference between momentum and reversal strategies?

Momentum: buy recent winners (short-term); Reversal: buy recent losers (long-term mean reversion).

What are the three forms of EMH?

Weak-form, Semi-strong form, Strong-form.

What are the three supports of market efficiency?

1) Rational investors, 2) Errors are uncorrelated, 3) Unlimited arbitrage.

What is the joint hypothesis problem?

You cannot test EMH without assuming a correct asset pricing model.

Name two prominent anomalies.

Momentum and the value premium (high B/M stocks outperform).

What are limits to arbitrage?

Risks/costs that prevent rational traders from exploiting mispricings (e.g., noise trader risk).

What does the Fama-French 3-factor model include?

Market return, size premium (SMB), and value premium (HML).

What does the regression LTIV = β₀ + β₁log(S) + β₂log(B/M) + β₃MQ show?

Managers irrationally prefer large, low B/M, high-quality firms — evidence of representativeness.

What is the behavioral interpretation of this regression?

Investors associate “good” characteristics (size, quality) with future returns, ignoring price.

What does the BSV model explain?

Alternating investor regimes (momentum vs. reversal); explains time-varying mispricing (optional).

What is the house money effect?

People are more willing to gamble with recent gains — treating gains as “not their own money.”

What is the break-even effect?

People take riskier bets to recover from previous losses.

How does mood affect investor behavior?

Bad mood (e.g., from weather or sports loss) can reduce risk appetite and market activity.

What did Deal or No Deal research reveal about framing?

Contestants integrate earlier gains/losses into future choices — mental accounting in action.

What is the winner–loser weight difference?

Investors tend to allocate more to past winners and less to losers — return-chasing behavior.

What is realization utility?

Positive emotion from selling at a gain, negative from realizing a loss — drives disposition effect.

How do behavioral explanations differ from risk-based ones?

Behavioral: driven by cognitive biases & limits to arbitrage; Risk-based: anomalies = priced risk.